Efficient Market Hypothesis & Random Walk Theory
- What is Efficient Market Hypothesis?
- Strong EMH
- Semi-strong EMH
- Weak EMH
- Random Walk Theory
- The Case for Efficient Market Hypothesis
- Why Market Efficiency is Important
The Efficient Market Hypothesis (EMH) is an investment hypothesis which advances the belief that the prices of financial assets reflect all the available information. Based on this, it is believed that one cannot consistently ‘beat the market’ based on risk-adjustment only since asset prices will only react to new information.
While the EMH dates back to the 1900s, it was in the 1970s that Eugene Francis Fama, an American economist, discussed the idea in depth. Fama defined an efficient market as one where participants are rational in their profit pursuit in the market. All underlying, relevant information is available to all market participants freely, who compete intelligently using this information. Ultimately, an efficient market is one where the prices of various financial assets reflect their true intrinsic value.
Degrees of Efficient Market Hypothesis
Fama categorised 3 levels of EMH as follows:
In a strong-form EMH, all information (public or private) is discounted in the current price of financial assets. In such a scenario, the EMH posits that there is a perfect market, with investors having no edge entirely over the market. Thus, it is practically impossible to make returns higher than the market benchmark.
Considered the most plausible scenario, a semi-strong EMH suggests that all relevant public information is quickly reflected in the prices of financial assets. New information is quickly picked up and processed by market participants so that a new equilibrium is created as a result of the new supply or demand forces. In this form, investors can only gain an advantage if they possess information that is not readily available in the public.
In this form, the EMH suggests that asset prices have discounted all past relevant information. With historical information factored in, technical analysis strategies cannot give traders an edge in the market. However, incoming, new information (fundamental analysis) can help identify overvalued or undervalued assets in the market. Overall, the EMH proponents suggest that financial markets are inherently difficult to beat. But while this can be said to be true, the difficulty is not because prices are discounted in the market, but largely because the collective sentiment of investors tends to overshoot price movements.
The major criticisms of the Efficient Market Hypothesis have particularly always come from behavioural economists who have explained the inefficiencies of markets as a factor of investor vulnerability to various cognitive biases, such as information bias, as well as subjective human errors, such as poor analysis. As well, periodic market bubbles and crashes further serve as empirical evidence of the inefficiencies of financial markets. It may be possible to determine when a market is in a bubble or crashing, but it is not easy to establish how far it can rise or fall. A major argument against the EMH is that it is indeed possible to beat the market year after year for a long time. Legendary investors, such as Warren Buffet, have managed to consistently outperform the benchmark for many years on end. In recent years, investment fund, Renaissance Technologies’ Medallion, has managed to achieve a return of 2478% in just 11 years, from 2008.
Random Walk Theory
Another hypothesis, similar to the EMH, is the Random Walk theory. Random Walk states that stock prices cannot be reliably predicted. In the EMH, prices reflect all the relevant information regarding a financial asset; while in Random Walk, prices literally take a ‘random walk’ and can even be influenced by ‘irrelevant’ information. For investors, the Random Walk suggests that it is only possible to outperform the market by taking additional risks. The theory was first publicised in 1973 by Burton Malkiel in his book ‘A Random Walk Down Wall Street’ where he likened stock prices to ‘steps of a drunk man’ that cannot be predicted reliably. Proponents of the Random Walk theory advise investors to invest in passive funds, such as mutual funds, for a chance to realise profits rather than amplifying risks by trading individual stocks.
The Case for Efficient Market Hypothesis
Over the years, the EMH has been considered an academic concept that has attracted numerous criticisms. But there is also some evidence that makes a strong case for the EMH. The best evidence for efficient markets is the inability of major mutual funds, hedge funds and other professional money managers to consistently outperform markets in the long run. The fact that big financial institutions, which spend massive amounts in research, big data and advanced quantitative trading systems are unable to beat the market consistently, virtually suggests that markets tend to drift towards efficiency. Investors, such as Warren Buffet, stands out as an outlier.
A major argument against the EMH are the occurrences of bubbles and crashes. Interestingly, the EMH does not exactly suggest that bubbles and crashes cannot exist, but the theory does posit that such market anomalies cannot be forecasted accurately or consistently. Other evidence of efficient markets is mean reversion. Over a long period, poor performing stocks tend to eventually perform better in the same time period. There is also the case of market cycles, which confirm that investor behaviour remains the same and contributes to market efficiency throughout the year.
The theory of EMH has been so compelling that it has been used to enact legislation that guides fair practices in the financial markets. In the U.S., the theory of efficient markets has been used to administer justice and to even calculate damages in securities fraud cases.
Why Market Efficiency is Important
The idea of efficient markets ensures that investors always commit to only exploiting quality trading opportunities in the market. The only way to realise above-average profitability would be to search for short-lived market inefficiencies, such as arbitrage opportunities. Over time, these opportunities will be non-existent in the market, but when available, investors should always ensure they take advantage of them. The best thing about the Efficient Market Hypothesis is that general consensus dictates that there will never be a 100% efficient market. This essentially means that there will always be profit opportunities in the market. It is, therefore, important to build comprehensive and relevant EMH knowledge and skills to be able to take advantage of such market opportunities. A better understanding of EMH principles will help investors greatly minimise their risk exposure in the market, while greatly enhancing their profit potential.
Random Walk Theory FAQ
- Is the Efficient Market Hypothesis valid and useful?
The Efficient Market Hypothesis claims that all available information is already reflected in an asset’s price, making it impossible to outperform the market averages, or to choose individual assets that will outperform consistently. However, there are several schools of thought that challenge this. For example, momentum investing combines technical and fundamental analysis and claims some price patterns will persist, giving the trader an edge. Behavioural finance claims markets are driven more by investor psychology than by efficiency. And fundamental analysis believes certain ratios for valuing assets will predict outperformance and underperformance.
- Why is the Efficient Market Hypothesis important?
It is thought that the Efficient Market Hypothesis is important for traders because it can help them to make better trading decisions. By stipulating that markets are in general pricing in all available information traders are able to take advantage of market abnormalities when they do occur. While the idea of efficient markets means investors can’t make above average profits in the long-term, it is still possible to take advantage of short-term abnormalities to profit from them. And while some economists adhere strictly to the Efficient Market Hypothesis, others claim full market efficiency is impossible, so there is often some way to gain a trading edge in the short-term market movements.
- Why is the Random Walk Theory important?
Because the Random Walk Theory stipulates it is impossible for individuals to beat the performance of the market averages in the long run it is also stipulated that the best course of action is to only invest in a portfolio that mimics the entire universe of stocks. That this is the only way to match market performance without taking on excessive risk. But this is for long-term market movements. In the short-term the Random Walk Theory may not apply. This is borne out by the fact that there are individual traders who are able to beat the market averages over a long period of time by taking advantage of short-term anomalies in asset prices.
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